Published by: Journal of Asset Protection; Warren, GorhamLamont
Author: Patricia Donlevy-Rosen, Esq.
Date of Publication: November, 1999
Combining a carefully selected offshore annuity with a properly designed offshore trust can provide a powerful asset protection planning option.
Financially savvy clients with sizeable portfolios look to shield their investments from unexpected market fluctuations by portfolio diversification, and from creditor attacks by using asset protection plans that include offshore trusts. They may also seek to minimize the tax impact of their investments through the use of annuity products.
Having a client’s offshore trusts purchase appropriate offshore deferred variable annuities will give the client the opportunity to achieve desired diversification and performance, while minimizing the current tax burden and diminishing the threat of potential future litigation.
Annuities are contracts wherein one party agrees to make a payment or a series of payments at an agreed time to another party. Contracts qualifying for U.S. income tax purposes as annuities will provide a tax deferred (not tax-free) structure within which investments may grow. “Tax deferred” means that U.S. income taxes will not be imposed on the earnings and gains generated within the annuity contract for a given period, provided that specific statutory and regulatory requirements are satisfied.
The parties to the annuity transaction are the issuer, the owner, the annuitant, and the beneficiary. The issuer is the person or entity undertaking to make payments under the annuity contract, and under some contracts, to invest the premiums and credit the earnings. The owner, usually an individual, is the one who pays the contract premium, chooses the annuitant (who may be him or herself), and is entitled to surrender the contract at any time, in whole or in part, for the contract’s cash value and receive payments while the annuitant is alive.
Generally, the owner is also the relevant taxpayer, even if some portion of the annuity payment is assigned to someone else. If, however, a deferred annuity is annuitized and provides that its payments are to be made to someone other than the officially named owner, that other person may be considered to be the de facto owner of the contract once the annuitization occurs. If so, that other person may be the taxpayer with respect to the annuity payments.
The annuitant is the individual whose life measures the contract’s payment period; the annuitant may also be the owner. Reg. 1.72-1(e) defines the annuitant as the payee–“a recipient shall be considered an ‘annuitant’ if he receives amounts under an annuity contract during the period that the annuity payments are to continue, whether for a term certain or during the continuing life or lives of the person or persons whose lives measure the duration of such annuity.” The beneficiary is the party entitled to receive payments due under the contract, if any, following the death of the annuitant or owner. Annuities are traditionally classified by:
- The method of payment – lump sum or periodic.
- The time at which the annuity payment begins – immediate or deferred. A deferred annuity is an annuity under which the commencement of payments is postponed until a specified date or event.
- The measure of the units in which amounts are accumulated or payments made – fixed or variable. For example, a deferred fixed annuity would guarantee a rate of interest to be credited to all premiums paid from the date of the purchase until the annuity commencement date. A variable annuity, on the other hand, would have no guaranteed rate of return on the premium paid, but would instead provide returns that varied with the investment performance and market value of the investments made by the issuer.
- The period over which payments will be made.
- The number of lives over which payments will be made.
Deferred annuities are very popular because they permit the value of the contract to increase tax free during the “accumulation period,” that is, the time before payments begin. At any- time, but preferably after the expiration of penalties for premature surrender both under the contract and the Internal Revenue Code (IRC), the owner may elect to:
(1) surrender the contract for a lump sum;
(2) take staged withdrawals;
(3) elect a one-life or two-life annuity either with or without a guaranteed minimum; or
(4)leave amounts on deposit with the issuer to pay interest.
Staged withdrawal is usually chosen as it avoids the immediate tax incurred on a lump-sum distribution and the mortality risk and lack of flexibility associated with annuitization. Penalties apply for premature withdrawals and the death of the owner triggers a required distribution. An election for annuitization should be made within 60 days of the date the contract provides for a lump-sum distribution to avoid the constructive receipt of income.
A variable annuity provides the investor with a choice of investment alternatives under the annuity contract. IRC Section 817(g) defines a variable annuity contract as a contract that provides for the payment of a variable annuity computed on the basis of recognized mortality tables and either (1)the investment experience of a segregated asset account, or (2) the company-wide investment experience of a company that issues only variable annuity contracts. The contract will not qualify as an annuity unless the diversification requirements of IRC Section 817(h) are met in the segregated asset account.
The deferred variable contracts that we are considering are non-qualified annuities for federal tax purposes. (A discussion of qualified retirement plan annuities is beyond the scope of this article.) A nonqualified annuity is one issued apart from a tax-qualified pension, profit sharing, or retirement plan or arrangement. Premiums paid on it are paid in after-tax dollars; they are neither excludable nor deductible from gross income for federal tax purposes, and are not subject to limits (of premiums paid) under federal tax law. The IRC, the income tax and estate and gift tax regulations that explain the IRC’s rules, judicial decisions, and IRS rulings (public and private), prescribe their federal tax treatment.
While no income taxes were due on the annuity as it had earnings, income taxes will be due once a distribution is made from the annuity. Distributions are classified as:
- Annuity distributions, cited as an “amount received as an annuity” in IRC Section 72.
- Non-annuity distributions, cited as an “amount not received as an annuity” in IRC Section 72.
Under the IRC, a part of each annuity distribution will be deemed to be a return of the moneys paid for the contract, or “the investment in the contract” as referred to in IRC Section 72. This “investment in the contract” is the aggregate amount of premium or premiums paid, which were not deductible for income tax purposes by the taxpayer upon purchasing the nonqualified annuity.
Therefore, such return of the “investment in the contract” will be received tax free. The other part of each payment will be deemed to be the previously tax-deferred earnings on the contract and is subject to current taxation as ordinary income. The IRC provides an “exclusion ratio” to ascertain the taxable and nontaxable parts of each distribution.
With respect to fixed annuities, the investment in the contract is certain at the annuity starting date, so the exclusion ratio is a fraction, the numerator of which is the investment in the contract, and the denominator of which is the expected return under the contract. For purposes of computing the exclusion ratio, the investment in the contract is fixed and determined at the annuity starting date.
IRC Section 72(c)(4) defines the “annuity starting date” as the first day of the first period for which an amount is received as an annuity under the contract. (Annuity starting dates occurring before 1/1/54 are deemed to be 1/1/54.)
The investment in the contract is defined to consist of the aggregate amount of premiums or other consideration paid for the contract, minus the aggregate amount received under the contract before the annuity starting date, to the extent that such amount was excludable from gross income under IRC Section 72(c)(1).
The expected rate of return to be used in computing the exclusion ratio depends on the type of annuity contract involved. Where the life expectancy of one or more individuals will be used to determine the expected return under the annuity contract, actuarial tables are prescribed by the IRS for the purposes of determining the expected return.
In other fixed annuity contracts, such as a 20-year term contract, the expected return is the total amounts receivable under the contract as an annuity. The resulting fraction is then used to determine the part of each distribution which is an “amount received as an annuity” and thus, not subject to U.S. income tax.
Once the investment in the contract has been completely distributed, any further annuity payments will be fully taxable (i.e., no further exclusion) if the starting date of the annuity was after 12/31/86. If the starting date was before 1/l/87, the exclusion ratio is applied perpetually to distributions.
With variable annuities, however, where payments are expected to fluctuate in amount, the expected rate of return cannot be determined at the starting date. The excludable portion of each periodic payment must be determined using a special rule under Regs. 1.72-2(b)(3) and 1.72-4(d)(3). This provides that:
1.The expected return equals the investment in the contract, such that the exclusion ratio is 100%.
2.The amount received as an annuity with respect to each payment received – i.e., the amount that is received tax free-equals the amount of the investment in the contact allocable to the payment period. This amount is calculated by dividing the number of expected payments into the total investment in the contract.
3.The balance of the payment is the amount not received as annuity after the annuity starting date, and it is fully includable in gross income.
If, however, the amount that is received in a year is less than the amount of the investment in the contract allocable to that year, the taxpayer may elect to redetermine the amount received as an annuity in the manner prescribed in the regulations.
For example, A buys a variable annuity for a $50,000 premium, choosing a variable payment option with annual annuity payments for life. On the annuity starting date, A has a 25-year life expectancy. The excludable amount of each payment would be calculated by dividing the investment in the contract by the annuitant’s life expectancy ($50,000 = 25 = $2,000). The non-annuity portion, the taxable portion, would be the total payment (which would vary depending on investment performance) minus $2,000. In other words, if the first variable annuity payment were $4,500, $2,000 would be treated as an annuity payment and not be taxable, leaving $2,500 to be included in income as an amount not received as an annuity after the annuity starting date.
An owner/investor should be aware of the consequences of using annuities to avoid unanticipated tax liabilities. The income tax treatment of non-annuity distributions depends on whether such payments are received before or after the annuity starting date.
When non-annuity distributions (e.g., lump-sum withdrawals) are made before the annuity starting date, they are usually treated as first consisting of previously deferred income on the contract (to the extent thereof) taxable as ordinary income, and second, as a nontaxable return of the investment in the contract. (For purposes of IRC Section 72(e), the term “investment in the contract” has a slightly different definition than it has for purposes of determining the exclusion ratio.
The investment in the contract as of any date, for IRC Section 72(e) purposes, is defined as the aggregate amount of premiums or other consideration paid for the contract before the specified date, minus the aggregate amount received under the contract before such date, to the extent that such amount was excludable from gross income under IRC.)
Whenever annuity distributions are received after the annuity starting date, the distribution amounts are fully included in gross income to the extent of the deferred income in the contract, unless the distribution is for a full refund, surrender, redemption, or maturity. The owner/investor must be alert to the consequences of taking a loan using an annuity contract – the amount received is an “amount not received as an annuity” and is included in the owner’s gross income.
This is the situation whether the loan is received directly from the insurer or indirectly from a third party. Any part of the contract that is pledged or subject to an agreement to be pledged is treated as “an amount not received as an annuity.
Also, if an owner transfers an annuity contract as a gift, at the time of transfer that owner is deemed to have received an amount equal to the deferred income on the contract as a non-annuity distribution. The inclusion in gross income of this amount will increase the investment in the contract.
Another trap for the owner who might wish to make a full surrender, a partial withdrawal, receive a loan, pledge or give the annuity as a gift – in some way make an early withdrawal – is the penalty tax of 10% imposed by IRC Section 72(q), unless one of the specific exceptions are met. Before either purchasing an annuity or taking a distribution, the owner must remember that subject to certain exceptions, a 10% penalty tax is imposed on the taxable portion of distributions received from an annuity contract (e.g., before the recipient has attained age 59½).
The 1998 adoption by the IRS of final regulations classifying certain annuity contracts as debt instruments, subject to the original issue discount (OID) rules, created another problem for annuities as potential investment vehicles. If an annuity contract is treated as a debt instrument subject to the OID rules, the owner will be required to annually include in gross income the computed OID amounts for the applicable period.
Annuity contracts will, however, be excepted from treatment as debt instruments if IRC Section 72 applies to the contract and periodic payments under the contract are life contingent – i.e., periodic payments made not less frequently than annually for the life or joint lives of an individual(s).
Although one might assume that I RC Section 72 would also apply to such a contract, the issue is not discussed in the regulations. To avoid a problem in the future, before buying an annuity, one should secure a written opinion from a qualified U.S. tax attorney that the offshore annuity will be treated as an annuity for U.S. income tax purposes.
OTHER INCOME TAX ISSUES
The tax-deferred benefits of an annuity are only available where the annuity contract is held by a natural person, subject to certain exceptions under IRC Section 72(u)(1). For the purposes of this discussion, the pertinent exception is the “trust/agent” exception. It appears from the legislative history and private letter rulings addressing this exception that the trust/agent exception will apply in the case of a natural person who is treated as the owner of a trust under the grantor trust rules.
Ltr. Ruls. 9810015, 9639057, 9322011, and 9316018 said that grantor trusts held contracts as agents for the grantors (who were natural persons). In the first two of these rulings, the IRS applied principles under the Second Restatement of the Law of Agency to find that a trust subject to control of the grantor(s) was the grantor’s agent. Even without this degree of control, under Rev. Rul. 83-13, the grantor should be treated as the tax owner of the annuity held in his or her grantor trust.
Therefore, the exception will be available to a foreign trust created by a U.S. person with U.S. beneficiaries. Such a trust is a grantor trust under IRC Section 679 (other grantor trust rules under IRC Sections 671 to 677 may also be applicable). On the other hand, the exception will probably not be available in situations where a corporation creates a trust to acquire an annuity contract.
U.S. ESTATE AND GIFT TAXATION OF ANNUITIES
The transfer without consideration of a deferred annuity by an individual owner is subject to federal gift tax where the gift is complete. A gift of an annuity contract is complete if the donor relinquishes all rights in the contract. A gift may be limited to a gift of an annuity payment or payments. Therefore, the gift tax may be applied when a donor gives as a gift to a donee either the entire contract, a series of payments, or a single payment.
If the gift is complete and the gift tax rules do apply, a taxpayer/donor may give up to $10,000 as gifts (indexed for inflation after 1998) in a calendar year to each of an unlimited number of donees without incurring a gift tax for the donor or an income tax for the donee, just as with other types of property. On any amount in excess of the $10,000 (or applicable amount in years after 1998), the donor must either pay gift tax or decrease the unified credit available to him or her under the estate tax. This would apply to a transfer to an irrevocable trust where the gift is complete.
On the other hand, a transfer to a trust established by the annuity’s owner, where such trust qualifies as a grantor trust under IRC Sections 671 to 679, will not result in any federal estate or gift tax consequences. Alternatively, the grantor trust itself could use its own funds to purchase an annuity contract without any special estate or gift tax consequences, as long as the arrangement qualifies for the trust/agent exception for income tax purposes, discussed above.
IRC Section 2039 does require the inclusion in the gross estate of a decedent (grantor/donor/owner) of the present value of an annuity or other payment receivable by any beneficiary by reason of surviving the decedent. Thus, whether the annuity is held by an individual or by the donor’s grantor trust, the present value of the annuity at the date of death of the grantor/owner/donor will be included in the grantor/owner/donor’s estate.
This rule applies to the part of the payment receivable by any beneficiary by reason of surviving the decedent as is proportionate to that part of the purchase contributed by the decedent. So if the decedent made no contribution to the annuity contract premiums, nothing will be included in his or her estate. Likewise, if annuity payments stop at the owner’s death, nothing is included in the gross estate.
ADVANTAGES OF OFFSHORE ANNUITIES
Offshore annuities provide a wider variety of investment options than do U.S. annuities. In general, U.S. variable annuity contracts limit the investment of the monies paid into them to a menu of mutual funds, and those mutual funds are further often limited to those offered by the same insurance company that issued the annuity contract.
These investment choices may include general equity funds, balanced funds, bond funds, and specialty funds such as international funds. The portfolios of these funds may have many different managers, either affiliates of the life insurance company or independent investment advisers. Federal tax law imposes strict limitations on the investments and the ability of the contract owner to select the investments – that is, the investments must be adequately diversified and the owner may not possess investor control.
A carefully selected offshore annuity will provide more investment options. Instead of limiting the investments to a menu of the issuer’s mutual funds, the client’s chosen investment advisor (but not the client) can direct the annuity investments in any type of security (subject to reasonable diversification requirements): gold, bonds, SPIDERS, AOL, etc.
The investment advisor can be the client’s existing U.S. investment advisor or any other unrelated person chosen by the client. The investment, however, must be diversified and must be held in a segregated account as provided in I RC Section 817(h). If not, the owner will lose the tax deferral altogether and will be taxed currently on all income earned under the contract.
With offshore annuities, the internal investment portfolio of the annuity contract is not derived from a menu supplied by the issuer, such that estimated investment returns are not quoted – they are variable. The variable return will be determined solely by the performance of the investments in the owner’s underlying segregated account (i.e., no minimum guaranteed return or cap, but tax deferred). Such a segregated account has the added benefit of not including the client’s assets in the balance sheet assets of the issuer and, thus, not subjecting the client’s assets to the debts of the offshore issuer.
WEALTH PRESERVATION STRATEGIES
An offshore issuer with no U.S. agents, subsidiaries, affiliates, or other U.S.–based connections will not be subject to the jurisdiction of a U.S. Court. This is a valuable wealth preservation tool, because a garnishment or attachment order issued by a court in the U.S. will be meaningless to the offshore annuity issuer. A U.S. claimant (against the owner of the annuity) would have to seek an order from an appropriate court in the country where the issuing entity is resident to effect a garnishment (if such a remedy is even available in that jurisdiction). This benefit would not be available if the annuity contract is owned by a person who is subject to the jurisdiction of the U.S. court.
If the owner is a person subject to the jurisdiction of a U.S. court, that owner could be ordered to exercise his or her rights under the contract for the benefit of the owner’s claimants, including requiring the owner to surrender the contract and pay over the proceeds to the claimants. Thus, greater protection can be obtained by having the annuity contract owned by an offshore trust that is not subject to the jurisdiction of any U.S. court.
Some states, as well as some foreign jurisdictions have adopted specific legislation providing for protection of annuity contracts from creditors of the owner and the beneficiaries. In Switzerland, for example, creditors are precluded from reaching assets in an annuity, but the annuity contract must be irrevocable and it may only have one or more individuals (but no entities) as beneficiaries. Although the creditor protection offered by such annuities is virtually absolute (even though owned by a U.S. person), the required beneficiary designations make it difficult to integrate this type of annuity in a U.S. individual owner’s estate plan. Whereas, if the offshore trust is named as the beneficiary, there is substantial flexibility, as discussed below.
The offshore annuity is a wealth preservation tool because the existence of the annuity is not as apparent as are most other investments. Foreign financial and bank accounts must be reported by U.S. citizens and residents (and their trusts). Annuity contracts, however, do not fall within the foreign financial account or bank account classification. So annuity contracts are not subject to the foreign account reporting requirements, and are, therefore, less easily discovered. The annuity’s existence w ill not appear on the owner’s income tax return.
SECURING THE UTMOST PROTECTION AND FLEXIBILITY
By having an offshore trust own the offshore annuity contract, the client can secure the utmost protection and flexibility. As previously mentioned, if a U.S. person directly owns an offshore annuity, the annuity may not be protected from his or her creditors unless the laws of the state of residence of the owner specifically exempt annuities from the reach of creditors, as for instance, in Florida.
Even in states with specific exemptions for annuities, there will be no protection where it is found that the acquisition of the annuity was done with the intent to hinder, delay, or defeat the claim of a creditor, under applicable fraudulent transfer laws. Protection is weak, if at all, since a U.S. court having jurisdiction over the U.S. owner could order the owner to surrender the contract and repatriate the funds. On the other hand, if a properly structured offshore trust owned the offshore annuity, no U.S. court would have jurisdiction over either the owner (offshore trust) or over the offshore issuer. Protection is strong, if not absolute.
Protection is subject, of course, to the fraudulent transfer rules of the trust’s situs jurisdiction, which rules should be — if the proper jurisdiction has been chosen — much more pro-debtor/investor/grantor than the fraudulent transfer rules of any state in the U.S.
Besides providing more investment options and substantially stronger protection for the investment, greater flexibility for distribution of the proceeds can be obtained by holding an annuity in an offshore trust through the dispositive provisions of the trust. For example, the trust can authorize the trustee to withhold direct distributions to a drug-addicted, alcoholic, or otherwise impaired beneficiary.
The trust can also set forth the means by which the trustee may use trust assets or income for an impaired beneficiary without making a direct distribution to that impaired individual. An annuity contract provides only for direct payments to an owner or beneficiary; it cannot provide the amount of flexibility provided by using a trust. Similarly, under a properly drafted trust, a trustee can be authorized to withhold a direct distribution to a beneficiary involved in litigation, including divorce and the like. Instead of making distributions to a beneficiary directly to a beneficiary impaired or in litigation, a trustee may be authorized to employ trust assets and pay income indirectly for the benefit of a beneficiary; an annuity contract alone cannot provide this flexibility.
Income Tax Advantage
Ownership of the offshore annuity by an offshore trust provides another income tax advantage to the surviving beneficiaries. During the life of the U.S. grantor/donor of the offshore trust, all annuity payments received by the offshore trust will be taxable on the U.S. income tax return of the U.S. grantor/donor – as if they were received directly by the U.S. grantor/donor, in the manner described above. After the death of the grantor/donor, however, payments from an offshore annuity made to a foreign trust will only be taxable as ordinary income to the beneficiaries when actually distributed to them by the trust.
Even though the value of the annuity payments received after the owner’s death are includable in the decedent’s gross estate to the extent of the consideration therefor furnished by the decedent, pursuant to IRC Section 2039, a stepped-up basis in the annuity contract is denied by IRC Section 1014(b)(9)(A). Such an additional deferral benefit is not available for the surviving beneficiaries when the owner/annuitant is the decedent rather than an offshore trust.
A Small Tax Cost
IRC Section 4371 imposes a “one-time” 1% excise tax on the premium paid for an annuity contract purchased by a U.S. person issued by a foreign issuer on the life of a U.S. citizen or resident person. This tax is imposed on the U.S. person making the annuity premium.
Therefore, the tax would be due even if the annuity were acquired by the U.S. person’s offshore trust. Some states impose a like excise tax on annuities sold by U.S. Issuers. Nevertheless, this cost and the acceptance fee charged by reputable issuers will be competitive with the initial load charges of U.S. issuers, especially when considered with the advantages discussed here
PURCHASING THE ANNUITY
If a U.S. individual buys an offshore annuity directly, he or she completes the application, submits it to the issuer, and upon its acceptance, wires funds representing the premium to the account designated by the issuer. (See the Practice Tip at the end of this article for information regarding selecting the issuer.) If the more protective and flexible route is taken, the offshore annuity will not be held directly by a U.S. individual, but in an offshore trust.
To accomplish this, the offshore trustee, not the U.S. individual/grantor, will complete and submit the annuity contract application to the issuer. When the issuer approves the application, the U.S. individual/grantor will wire funds for the premium to a bank account of his or her offshore trust. The offshore trustee will then transfer the premium amount to the account of the issuer, and the annuity will have been implemented.
Offshore annuities offer many advantages, especially when held by a properly structured and drafted offshore trust. The steep minimum initial premium required by most offshore issuers – as much as $2 million – will, however, keep it from being an appropriate investment vehicle for many. When appropriate, the offshore annuity is a valuable wealth enhancement and preservation tool.
Omitted. Call 305-447-0061 for a free reprint of this article including endnotes.
This article is displayed with the permission of the publisher. Unauthorized reproductions are not permitted.
Donlevy-Rosen & Rosen, P.A. is a law firm with a focus on asset protection planning and offshore trusts. Attorneys Howard Rosen and Patricia Donlevy-Rosen co-founded the firm in 1991, and have since become recognized authorities in the field of asset protection planning. Let us explain the significant difference our experience can make when protecting your assets. Call 305-447-0061 or simply visit our contact page